TRANSACTION COST THEORY

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TRANSACTION COST THEORY

• Ronald Coase (1937) posed two Nobel-prize puzzles
  
• Why do any firms emerge in a market economy?
• Why not just One Big Firm for whole economy?

Neoclassical economics treats the firm as a
production function that efficiently transforms
land, labor capital inputs into goods
services. Competitive markets coordinate
buyer-seller exchanges via price signals.
Coase argued that market mechanism not cost-free,
but involves transaction costs time money to
search for sellers buyers, negotiate exchange
terms, write contracts, inspect results, enforce
deals
Firms will emerge if an economizing
organization can reduce its production
transaction costs lt market prices Firm expansion
halts when intra-orgl TC gt market prices
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The Costs of Transacting
Transaction The transfer of a good/service
across technologically separable interface
(locational boundary) EX Machine-scoring of
multiple-choice exams Reserve reading
materials
Transaction costs of making, enforcing agreements
EX How much to conduct your one-time social
survey?
Transactions are embedded within social,
political, legal institutional environments that
affect transaction costs. These rules of the
game affect property, production, distribution,
and exchange relations among economic actors EX
EPA regulations about lead pollution emissions
Transaction cost theory seeks to explain
variations in forms of governance of economic
exchanges
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Forms of Governance
Oliver Williamson (1975, 1981) identified three
fundamental forms of transaction governance and
the conditions when theyre likely to occur
Market Autonomous parties exchanges are
governed by prices in supply-demand equilibrium
Hierarchy (Formal org) Transactions among
parties occur under a unified owner, who settles
disputes by administrative fiat Hybrid
Long-term contractual relations that preserve
parties autonomy, but provide added
transaction-specific safeguards as compared with
the market.
EX United Way and social service agencies
Strategic alliances agricultural cooperatives
Networks of small-medium suppliers and
manufacturers
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Behavioral Assumptions
Transaction parties can never write completely
detailed agreements covering all possible future
contingencies (incomplete contracting) Williamso
n assumed transactors abilities motives
involve
Bounded rationality Utility-maximizing,
intendedly rational transactors are constrained
by cognitive limits on their capacities to
process information efficiently (contrast to
neoclassical perfect info)
Opportunism Self-interest with guile could
induce strategic behavior by transactors to lie
to, cheat, confuse, mislead their exchange
partners
EX Used car salesmen political candidates your
prelim study group?
Even when opportunism risks are low, orgs must
still safeguard against possibly severe damages
from an opportunistic partner (worst case
scenario)
Nicolo Machiavelli
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Three Transaction Dimensions
Transactions have three key dimensions that
determine how their costs affect governance choice

• Uncertainty about environments, other actors

EX Floods delay factory suppliers just-in-time
deliveries

• Frequency of exchanges one-off or recurrent?

• Asset specificity investments lacking
  alternative uses except at loss of productive
  value asset specificities can be human skills,
  geographical sites, brand names, dedicated
  machinery

EX You buy a unique readings packet for this
course Chip supplier builds factory to
Dells computer specs
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Transaction Economizing ? Governance
Williamsons key claim Variations in exchange
governance forms result from efforts to economize
on transaction costs
His three transaction costs dimensions align
efficiently with transactors choices among the
three ideal forms of governance
Market Hybrid Hierarchy
Uncertainty LOW MIDDLE HIGH
Frequency LOW MIDDLE HIGH
Asset Specificity LOW MIDDLE HIGH
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Make-or-Buy?
Transaction cost theory examines the conditions
under which organizations chose to internalize
some functions (hierarchy) or to purchase them on
the market (e.g., relational subcontracting)
EX When should a firm or agency train its own
employees, hire external vendor (college or
commercial), or create a jointly staffed program?

• Are employee job skill requirements changing
  rapidly unpredictably?
• How often must newly hired or promoted workers
  be (re)trained?
• Would orgs own training staff have to invest
  heavily in asset-specific facilities, such as
  simulation labs?

• Is orgs own training staff more knowledgeable
  than external trainers about firm-specific and
  tacit skills needed by employees?
• Are external vendors competent, reliable cost
  efficient?

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More TC Applications
TC theory can be applied to explain diverse orgl
phenomena

• Difficulties in establishing micro-credit
  lending associations
• Unionization drive successes or failures
• Creation of company towns for miners, loggers
• Diffusion of conglomerate, M-form corporate
  structures
• Mergers-acquisitions vs. technology transfers
  among alliance partners
• Quarrels over which members own a defunct rock
  bands name
• (Pink Floyd, Yes, Flying Burrito Brothers)
  (Cameron Collins 1997)

• Band names are asset-specific capital for
  re-releases of oldies that fans will buy
• Reincarnated inferior group seeks undeserved
  rents from the reputations earned by their more
  talented predecessors

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TC Theory Critiques
TC theorys heavy emphasis on potentially
opportunism by employees partners is an
unwarrantedly pessimistic view of human nature
(but, economics is the dismal science)
Is TC as a normative prescription for orgl
best-practices?

• Moral dimensions of organizational behavior
  could reduce or replace need to make and enforce
  formal contractual safeguards against
  opportunistic risks of deceit and
  self-interested, guileful actions
• Trust among individuals between organizations
  is an alternative basis for lowering transaction
  costs
• Learning effectiveness increases with
  transactors beliefs in an information sources
  competence and goodwill
• Self-actualization motives (work- and
  org-commitments) orient participants towards
  collective performances
• Empowerment to make work decisions gives
  participants a stake in achieving better
  performance outcomes

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PRINCIPAL-AGENT THEORY
Principal-agent theory shares TC concepts of
uncertainty, opportunism, externalization,
cost-efficiency calculations
Principal pays Agent to perform service in
exchange for fee
EX Hollywood sports agents negotiate contracts
for stars Board pays CEO megabuck to
boost share prices Trustees hire President
to raise Us academic prestige

• Information asymmetry How does Principal know
  if Agent is competent and working on behalf of
  Ps interests? (If P had necessary knowledge and
  skills, A would be unnecessary)
• Agency costs Principals search, monitoring,
  bonding costs to hire and supervise Agent (vs P
  doing the job herself)
• Opportunism (moral hazard) Risk-averse Agent
  tempted to deceive shirk duties pocket fee but
  not deliver the best deal

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Performance Incentives
Monitoring Agents skills activities is
difficult, so Principal could use
pay-for-performance incentives to encourage As
risk-taking and make A more accountable in
looking out for Ps interests
EX Make As compenation contingent on actual
outcomes CEO bonus, stock options depend on
annual share prices Teachers salary gains tied
to her students test scores
Problem Orgs performance affected by many
factors beyond agents control (fickle consumers,
govt regs, bad weather) In high uncertainty,
tying compensation to performance may actually
induce a risk-averse CEO to take timid,
less-risky actions in effort to avoid a major
loss to personal fortune
Major corporate CEO pay-performance effect very
weak only 3.25 per 1,000 change in
shareholder wealth 1 weeks pay (9,600 in
1980s) This amount judged small for an
occupation in which incentive pay is expected to
play an important role (Jensen Murphy 1990227)
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References
Cameron, Samuel and Alan Collins. 1997.
Transaction Costs and Partnerships The Case of
Rock Bands. Journal of Economic Behavior and
Organization 32171-183. Coase, Ronald H. 1937.
The Nature of the Firm. Economica 4386-405.
Reprinted pp. 33-55 in R.H. Coase. 1988. The
Firm, the Market, and the Law. Chicago
University of Chicago Press. Jensen, Michael C.
and Kevin J. Murphy. 1990. Performance Pay and
Top-Management Incentives. Journal of Political
Economy 98225-264. Williamson, Oliver E. 1975.
Markets and Hierarchies Analysis and Antitrust
Implications. New York Free Press. Williamson,
Oliver E. 1981. The Economics of Organization
The Transaction Cost Approach. American Journal
of Sociology 87548-577.